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Japanese equities: Looking beyond the recent highs

Japanese equities are at 15-year highs, but does that mean the market is over-heating or are there fundamental reasons behind the rise more robust than when the market previously saw these levels in 2000? Andrew Rose, Japanese equities fund manager at Schroders, investigates.

06/23/2015

Andrew Rose

Fund Manager, Japanese Equities

Nikkei passes 20,000 for first time in 15 years

Yen at 12-year low vs dollar

Equities in stronger position now than in 2000

Coporate governance and dividned yields more robust in 2015

Cautious optimsm remains over Japnese equities

Japanese equities hit 15-year highs

Recent headlines in Japan have been dominated by a flurry of multi-year stockmarket highs and currency levels being hit. Digging a little deeper, though, we still find plenty of reasons to remain positive.

One of these landmarks, the Nikkei Index surpassing the 20,000 level for the first time in 15 years, also occurred in conjunction with the longest ‘winning’ streak since 1988.

In addition, the market capitalisation of the Japanese stockmarket has hit its highest ever level while the Japanese yen has sunk to a 12-year low versus the dollar.

The weak yen has certainly helped the stockmarket in its recent resurgence but how does this rally compare to the last time the Nikkei was above 20,000?

In 2000, shortly after the index topped this level, it then proceeded to drop by two-thirds over the following two years.

Are conditions different in 2015 vs 2000?

Although the question is broad, from a valuations perspective at least, the picture is brighter.

The aggregate price-to-earnings ratio (PER) today is around one-third or half of its 1989 and 2000 levels, respectively.

Furthermore, the comparisons for the price-to-book (PB) ratio are one-fifth and half.

In terms of companies’ Return-on-Equity (RoE), average RoEs today are about double what they were in 2000.

This is an encouraging sign of the relatively more salubrious condition of corporate Japan in 2015.

Even though this, less fortuitously, also marks a return to the RoE levels of the market in 1989, just before the crash, a closer look at the data does provide some comfort.

Balance sheet gearing was higher in 1989 while the quality of earnings today is higher, either through more reliable accounting procedures or less of a reliance on non-recurring financial market profits.

Better governance yielding dividends

Back in both 1989 and 2000, the dividend yield of the market offered little downside protection given its low absolute level (sub-1%).

However, in the current market yields are higher and the potential for payouts to grow is also more promising as a superior profits outlook has allowed management to be more generous in paying out dividends.

Measures to raise shareholder awareness and improve corporate governance of Japanese companies have also helped.

The introduction of a Corporate Governance Code has brought about generally more positive corporate behaviour from management, such as the setting of RoE targets and an increase in share buybacks.

The adoption of a Japanese Stewardship Code last year, which aims to ensure institutional investors are more transparent on how they vote at AGMs while also engaging more actively with company management, should also help to drive a longer-term sustainable growth in the corporate sector.

Improved prospects for the economy

Despite the anaemic growth recovery of Japan’s economy, following its exit from recession in the last quarter of 2014, the outlook is significantly brighter on the back of lower oil prices.

A weaker yen has helped manufacturing climb out of its slump, with industrial production and exports numbers starting to show a gradual improvement.

Policy is also supportive. The widely-recognised ‘three arrows’ of Abenomics are in action, with the first two arrows of monetary easing and fiscal stimulus.

The Bank of Japan (BoJ) has continued to add government bonds to its balance sheet while flexible fiscal policy has relieved downward pressures on the economy.

A postponement until April 2017 of the second consumption tax rate hike and supplementary budget measures to help support families and SMEs are some of the more positive moves by the authorities.

Meanwhile, unemployment remains at multi-year lows with the labour market remaining tight. Real income growth is also set to turn positive as wages pick up.

Cautiously optimistic

Overall, trends are generally positive for the corporate sector in Japan, as profits and shareholder returns both continue to expand.

Indeed, there is also room to improve areas of corporate governance but the current measures in place are ensuring this transition, albeit long-term, will further strengthen the investment case for Japanese companies.

An uptick in the allocation of the GPIF – the world’s largest pension fund – to Japanese equities is also having a positive effect on the stockmarket.

Although investors should be aware of potential risks over the short- to medium-term, such as possible economic disappointment or geo-political worries related to China, the long-term case for investing in Japanese companies is relatively bright.

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